After a lacklustre 2013, when the mid- and small-cap category of funds yielded an average return of only 2.83 per cent, it is enjoying a good run this year. It is up 5.53 per cent year-to-date (27 March). The trailing one-year return for the category stands at an attractive 24.97 per cent.

Besides the stellar performance, the primary reason for investing in these funds is diversification. While the large-cap category outperforms in some years, the mid- and small-cap category does so during others. By having an exposure to the latter, you ensure that your portfolio benefits whenever this category does well.

Since the mid- and small-cap category is less intensively researched than the largecap one, fund managers have a greater scope for benefiting from discrepancies between price and intrinsic value. Says R Srinivasan, head of equity, SBI Mutual Fund: "There is scope for research arbitrage given the low quantum and quality of research in this category relative to large-caps."

Chirag Setalvad, senior fund manager, HDFC Mid-cap Opportunities, offers another reason. "There is a misconception in India that mid-cap companies are of poor quality, and that they are highly leveraged and badly run. This misconception creates a price advantage. If you focus on high-quality companies in this space, you can earn reasonably good returns," he says.

However, mid- and small-cap funds also tend to be more volatile than large-cap funds due to several reasons. One, the companies in this category are in a growth phase, so their finances tend to be less robust. During a downturn, the probability of failure is higher among them. Second, in difficult times, investors turn risk-averse and exit mid- and small-cap stocks, which turn illiquid. Investors then find it difficult to exit, except at a steep discount. All these factors affect the NAVs (net asset values) of mid-cap funds.

To benefit from these funds' higher potential returns while reducing volatility, have a limited exposure to them. A 70-75 per cent exposure to large-cap funds and 25-30 per cent exposure to mid- and small-cap funds is regarded as standard. You could have a lower exposure to the latter as you get older if your financial situation is precarious, or if your risk appetite is low. Finally, make the higher volatility in these funds work in your favour by investing via SIPs.

HDFC Mid-Cap opportunities: Focusing on quality

This almost seven-year-old fund has an enviable track record (see graph). Currently, it has assets under management (AUM) worth Rs2,802.96 crore. This is a blend fund, which holds both growth and value stocks in its portfolio. Chirag Setalvad, who has been handling this fund since March 2008, follows a largely bottom-up approach to stock-picking.

The fund manager focuses on stocks that have the ability to grow their earnings by 15-20 per cent annually. The company must also have a track record of generating cash flow, and must offer attractive return on equity (RoE) and return on capital employed (RoCE). Besides all these qualities, the stock must also be available at a reasonable valuation.

The fund manager runs a well-diversified portfolio which currently holds 64 stocks, much higher than the average of 46.42 for the mid- and small-cap category. The fund manager follows the buy-and-hold approach. In February, the fund had a turnover ratio of 33 per cent, much lower than the category average of 79.72 per cent. At 2.13 per cent, the expense ratio was lower than the category average of 2.53 per cent.

The fund manager avoids high cash calls: over the last one year, ended February 2014, the fund had an average allocation of 3.33 per cent to cash. The fund's level of risk is lower than the category average, while its risk-adjusted returns are nearly double the category average (paramaters calculated over trailing three years). The manager's unwavering focus on creating a portfolio of high-quality, sustainable businesses purchased at a reasonable price, and the fund's consistent adherence to its mid-cap mandate make it a sound pick.

SBI Magnum Global 94: Betting on sustainability

Started in June 2005, this growth-oriented fund has an AUM of Rs863.57 crore. R Srinivasan, who has been managing it since July 2009, follows a bottom-up approach. This is combined with a top-down assessment to determine sector allocation, and thereby contain risk. The fund manager focuses on companies that have a 'right to win', which refers to companies that have a dominant market share, strong brand, superior business model, technological edge, core competency or some other characteristic that will ensure its long-term sustainability.

Srinivasan also looks for stocks that have the ability to grow their earnings by 18-20 per cent annually. Scalability of business is another quality he considers desirable. The management of companies he invests in must possess both integrity and competence.